Tax Advantages of Drilling for Natural Gas & Oil
There are two incentives to drilling for natural gas & oil in the U.S. These incentives are not "loop holes" and apply to any U.S. income.
1. Up to 100% of your investment can be tax deductible (See "IDC" below).
2. The income from producing properties can be 15% tax free (See "Small Producers Tax Exemption" below).
Intangible Drilling Costs (IDC)
The intangible expenditures of drilling (labor, chemicals, mud, etc.) are usually about 70%-80% of the cost of a well. These expenditures are considered "Intangible Drilling Costs (IDC)", which are 100% deductible during the first year. For example, a $100,000 investment would yield up to $80,000 in tax deductions during the first year. These deductions are available in the year the money was invested, even if the wells do not start drilling until March 31st of the following year.
Tangible Drilling Costs
The total amount of the investment allocated to the equipment, or “Tangible Drilling Costs”, is 100% tax deductible. In the example above, the remaining tangible costs $20,000 may be deducted as standard depreciation over a 7 year period.
Small Producers Tax Exemption
The 1990 Tax Act provided some special tax advantages for small companies and individuals. This tax incentive, known as the "Percentage Depletion Allowance", is specifically intended to encourage participation in oil and gas drilling. The "Small Producers Exemption" allows 15% of the gross income from an oil and gas producing property to be tax-free.
Active vs. Passive Income
The Tax Reform Act of 1986 introduced into the Tax Code the concepts of "passive" income and "active" income. The Act prohibits the offsetting of losses from passive activities against income from active businesses. The Tax Code specifically states that a working interest in an oil and gas well is not a passive activity, therefore deductions can be offset against income from active stock trades, business income, salaries, etc. See IRS publication 925, "Passive Activity and At-Risk Rule."
What is 1031 Tax Free Exchange?
Under normal circumstances, when you sell a property you have to pay taxes on the gain. Gain is the net resultant of depreciated deductions allowed under U.S. tax law or the overall appreciated value of the property during ownership.
A Section 1031 tax deferred exchange, named for the Internal Revenue Code Section to which it refers (also known as a Starker Exchange), allows an exception to the capital gains taxes in instances where a person sells a business or investment property and directly reinvests the gains into another business or investment property. In these cases, the capital gains tax is deferred.
If your plans include using the money from the sale of a business or investment property to buy more of the same, a 1031 Exchange provides greater proceeds for your next investment. You will gain more than you could have gained through the re-investment of after-tax proceeds.
A 1031 Exchange is not a tax loophole. It is a section of the Internal Revenue Code, written by Congress, to allow anyone who meets all the requirements to sell their property and defer paying taxes on the gain. Producing Properties qualify for 1031 Exchange and the added benefit of the 15% depletion allowance.
Who should consider a 1031 Exchange?
Anyone who is thinking about selling a business or investment property should consider a 1031 Exchange. An Exchange offers the opportunity to reinvest the federal capital gains that would normally be exposed to the IRS for tax purposes and put that money back to work for the investor.
What Qualifies for a 1031 Tax Free Exchange?
The classification of properties as provided by the IRS determines if a property qualifies for Section 1031 treatment.
A. The IRS's 4 classifications of Real Estate:
1. Property held for personal use. (Personal Property)
2. Property held primarily for sale. (Dealer Property)
3. Property held for productive use in a trade or business. (Business Property)
4. Property held for investment. (Investment Property)
The last two classifications qualify for a Section 1031 tax deferral, whiled the first two do not. Both the property received and the property sold must be of "like-kind". It is your use of the property that determines its classification for tax purposes and not what any subsequent owners do with the property.
B. Like-Kind Property
1. Like-kind refers to your use of the property and not to its grade or quality.
2. "1031" property may be mixed as to type and still be like-kind. As an example, you may exchange land for a duplex, or a commercial building for a retail store, etc.
3. Property held outside the U.S. and its territories does not qualify for exchange with property held within the U.S.
C. Partnership Interests
Your interest in a partnership cannot be traded for an interest in another partnership. However, there is an exception: The partnership as an entity can exchange real estate it owns for other like-kind real estate.
D. Transfer Between Spouses
There are no income tax consequences in entering into financial transactions between spouses. In addition, most transfers incident to a divorce are tax free. However, transactions with a former spouse are normally subject to tax, unless they qualify for nonrecognition under the provisions of Section 1031.
E. Sale/Lease Back As An Exchange
A lessee’s interest in a lease with a term of 30 years or longer in real property is considered like-kind to other real property. In addition, property which is subject to a lease can be the subject of a tax free exchange, even if the lease is for a term of 30 years or longer. However, the receipt of prepaid lease payments in an exchange for a 30-year or longer lease is taxed as ordinary income and will not qualify for tax-free exchange treatment.
F. Business Assets
The personal property assets of one business can be exchanged for like-kind assets of another business and will be held as a like-kind exchange under Section 1031. The real property is treated the same as any other exchange. The like-kind requirements for personal property are much more stringent than for real property (e.g., a truck cannot be exchanged for a car, nor can a barge be exchanged for a cargo ship).
G. Vacation Homes & Properties
This type of property does not qualify if it is used solely for personal use. It may qualify if the property is rented, and must pass a use test each year.
Misconceptions About Exchanging
1. Many still believe that you must “swap” properties. Although this was required in the original code, this is rarely done in present times. 1031 Exchanges now enable one to sell his property to someone unrelated to the person from whom the owner is purchasing his replacement property.
2. Many believe only investors of large commercial properties can utilize the benefits of Section 1031. The nice thing about 1031 Exchanges is that it applies to all investment properties, large and small. It will work the same way for a corporation selling a large shopping center as it would for an individual selling a single-family home used as a rental property in a vacation area.
3. Many believe you must acquire a property of "similar use or service." While 1031 Exchanges are also known as like-kind exchanges, "like-kind" simply applies to real property held for business use or investment. Therefore, an investor may sell raw land and acquire a five-unit apartment building or sell a warehouse and acquire raw land. Virtually any type of real property used for business use or investment will qualify.
4. Many believe 1031 Exchanges are very complicated and not worth the effort. The fact is that when working with a qualified intermediary who specializes in Section 1031 tax-deferred exchanges, the exchange process is very simple. The intermediary will keep you aware of your time deadlines and ensure you do everything in strict compliance with IRS regulations.
Advantages of Exchanging
1. The exchanger will have more buying power because the federal income taxes are deferred. This enables the buyer to have greater leverage with additonal real equity for financing consideration and reinvestment.
2. Investors can do multiple exchanges, creating a pyramid effect. This tax liability is forgiven upon the death of the investor resulting in the heirs receiving a stepped-up basis on the inherited property.
3. The exchanger has greater selling power due to price flexibility. The seller can be more flexible regarding the selling price because he does not need to hedge for exposure to the capital gains tax.
4. The exchanger can acquire a replacement property with greater income potential. The exchanger can sell raw land and acquire income-producing property. For example; an exchanger may wish to sell one property in order to purchase another with additional rental units or in a better location.
5. The exchanger has the opportunity to consolidate several hard-to-manage properties into one easy-to-manage property, or diversify several small properties into one large property. It provides an excellent opportunity to relocate or expand a current business or investment.
6. An exchange can also help an investor acquire a less management-intensive property.
Please consult your tax advisor for specific information relating to your 1031 exchange.